"Markets can remain irrational longer than you can remain solvent." - John Maynard Keynes
The spread of contagion appears to be accelerating and fear has taken hold, particularly in the banking industry which is a vital component of the global financial system. This increases the likelihood that the ailment could become a threat to the overall health of the global economy. As I noted in my last Monday Macro View, this is not attributable to any specific cause, such as rising interest rates, but rather a manifestation of underlying issues that are now being highlighted. A thread of mismanagement and intrigue has been exposed, and we can expect to see similar instances replicated throughout the industry and even beyond. The latest domino to be hit by the contagion wave is Deutsche Bank, which has seen a precipitous drop in its share price.
So how does contagion spread?
[Initial Crisis or Shock] -> [Increased Market Volatility] -> [Investor Panic] -> [Sell-Offs and Liquidity Crunch] -> [Defaults and Bankruptcies] -> [Wider Economic Impact] -> [Contagion Spreads to Other Markets]
An interesting article in the Financial Times offers insight into "What's eating Deutsche Bank?" The sell-off of Deutsche Bank's shares is attributed to the "Friday Effect," a phenomenon in which it is considered best to sell banks before the weekend during times of crisis. However, analysts attribute the sell-off to the recent sub-CDS spreads blowout for European banks, which was in response to the weakness of AT1 debt instruments. While Deutsche Bank has significant exposure to US CRE, its CET1 ratio of 35% suggests that this exposure is manageable. Moreover, only €13.1tn ($14tn) of its €42.5tn notional OTC derivatives book is not centrally cleared, indicating a low level of counterparty credit risk. Deutsche Bank is profitable and is no more exposed to interest rate risk than the European banking average.
What does the CET1 ratio measure?
The CET1 ratio is a crucial indicator of a bank's financial strength, standing for "Common Equity Tier 1 ratio." Regulators use this metric to ensure that banks have enough capital to cover potential losses.
To calculate the CET1 ratio, a bank's risk-weighted assets (RWAs) are divided by its Tier 1 capital, which includes common equity and retained earnings. Essentially, the CET1 ratio measures the proportion of a bank's capital derived from its common equity.
A higher CET1 ratio means that a bank has a greater amount of common equity relative to its RWAs. This demonstrates that the bank is more financially stable and can withstand potential losses. Additionally, a higher CET1 ratio means that the bank relies less on debt and other sources of funding, which can be more costly and increase financial risk.
Although a CET1 ratio of 7% or greater is generally considered the minimum threshold for financial soundness, the necessary CET1 ratio can vary depending on the regulatory framework in a given region and the bank's unique circumstances.
What are other differences?
While Credit Suisse struggled, Deutsche Bank's CEO Christian Sewing implemented cost-cutting measures, resulting in an annual profit of €5.7bn (£5bn), the highest in 15 years. In contrast, Credit Suisse, which was only six months into a three-year turnaround plan, reported a loss of 7.3bn Swiss francs (£6.6bn) in 2022.
Credit Suisse, there is no indication of a mass exodus of depositors from Deutsche Bank. Additionally, while Swiss authorities advanced a 50bn Swiss franc borrowing facility to Credit Suisse before its forced sale to UBS, there are no reports of the European Central Bank being concerned about Deutsche Bank's liquidity.
In fact, the bank recently announced a decision to buy back a portion of its debt, a move that would not have been approved if regulators were worried about its liquidity.
Despite this, for the second Friday in a row, investors were alarmed by the plunging share price of a large European bank. At its lowest point, Deutsche Bank's shares had fallen by 14%.
For now, it seems that the episode is part of a larger fear that the banking crisis will continue to unfold. The share prices of all large European banks have fallen, with Deutsche Bank posting the heaviest decline of 8.6% by the close of the market.
There exposure to US CRE (Commerical Real Estate) is also manageable per Autonomous Research.
Contagion can spread further while the fear will continue to grip markets. It seems the feedback loop is in place and given the overall economic environment there are chances that this can get out of hand. Time will tell. Fasten your seatbelts.